Externalities, Endogenous Productivity, and Poverty Traps

We present a version of the neoclassical model with an endogenous
industry structure. We construct a distribution of firms’ productivity
that implies multiple steady-state equilibria even with an arbitrarily
small degree of increasing returns to scale. While the most productive
firms operate across all the steady states, in a poverty trap less
productive firms operate as well. This results in lower average firm
productivity and total factor productivity. The distributions of
employment by firm size across steady states are consistent with the
empirical observation that poor countries have a higher fraction of
employment in small firms than rich countries. Differences in output
and total factor productivity across steady states are increasing in the
degree of returns to scale, the capital share, and the Frisch elasticity
of labor supply.